Chapter

11

Managing Transaction Exposure

South-Western/Thomson Learning 2006

Chapter Objectives

To identify the commonly used techniques for hedging transaction exposure; To show how each technique can be used to hedge future payables and receivables; To compare the pros and cons of the different hedging techniques; and To suggest other methods of reducing exchange rate risk.
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Transaction Exposure
Transaction exposure exists when the
future cash transactions of a firm are affected by exchange rate fluctuations. firm faces three major tasks: Identify its degree of transaction exposure. Decide whether to hedge this exposure. Choose a hedging technique if it decides to hedge part or all of the exposure.
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When transaction exposure exists, the

Transaction Exposure
To identify net transaction exposure, a
centralized group consolidates all subsidiary reports to compute the expected net positions in each foreign currency for the entire MNC.

Note that sometimes, a firm may be able to

reduce its transaction exposure by pricing its exports in the same currency that it will use to pay for its imports.
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Techniques to Eliminate Transaction Exposure

Hedging techniques include:

Futures hedge, Forward hedge, Money market hedge, and Currency option hedge.

MNCs will normally compare the cash flows

that would be expected from each hedging technique before determining which technique to apply.
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Futures and Forward Hedges

To hedge future payables (receivables), a firm
may purchase (sell) currency futures, or negotiate a forward contract to purchase (sell) the currency forward.

The hedge-versus-no-hedge decision can be

made by comparing the known result of hedging to the possible results of remaining unhedged, and taking into consideration the firms degree of risk aversion.

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Futures and Forward Hedges

The real cost of hedging measures the
additional expenses beyond those incurred without hedging.

Real cost of hedging payables (RCHp) =

nominal cost of payables with hedging nominal cost of payables without hedging

Real cost of hedging receivables (RCHr) =

nominal revenues received without hedging nominal revenues received with hedging
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Futures and Forward Hedges

If the real cost of hedging is negative, then
hedging is more favorable than not hedging.

To compute the expected value of the real

cost of hedging, first develop a probability distribution for the future spot rate. Then use it to develop a probability distribution for the real cost of hedging.

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The Real Cost of Hedging for Each in Payables

Probability 5% 10 15 20 20 15 10 5 Nominal Cost Nominal Cost Real Cost With Hedging Without Hedging of Hedging $1.40 $1.40 $1.40 $1.40 $1.40 $1.40 $1.40 $1.40 $1.30 $1.32 $1.34 $1.36 $1.38 $1.40 $1.42 $1.45 $0.10 $0.08 $0.06 $0.04 $0.02 $0.00 $0.02 $0.05

For each in payables, expected RCH = Pi RCHi = $0.0295

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The Real Cost of Hedging for Each in Payables

25% 20%

Probability

15% 10% 5% 0% -$0.05 -$0.02 $0.00 $0.02 $0.04 $0.06 $0.08 $0.10

There is a 15% chance that the real cost of hedging will be negative.
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Futures and Forward Hedges

If the forward rate is an accurate predictor
of the future spot rate, the real cost of hedging will be zero.

If the forward rate is an unbiased predictor

of the future spot rate, the real cost of hedging will be zero on average.

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Money Market Hedge

A money market hedge involves taking a
money market position to cover a future payables or receivables position.

For payables:
Borrow in the home currency (optional) Invest in the foreign currency

For receivables:
Borrow in the foreign currency Invest in the home currency (optional)
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Money Market Hedge

A firm needs to pay NZ$1,000,000 in 30 days. Borrows at 8.40% for 30 days

1. Borrows $646,766 Exchange at $0.6500/NZ$ 2. Holds NZ$995,025

3. Pays $651,293 Effective exchange rate $0.6513/NZ$

Lends at 6.00% for 30 days

3. Receives NZ$1,000,000
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Money Market Hedge

A firm expects to receive S$400,000 in 90 days. Borrows at 8.00% for 90 days

1. Borrows S$392,157 Exchange at $0.5500/S$ 2. Holds $215,686

3. Pays S$400,000 Effective exchange rate $0.5489/S$

Lends at 7.20% for 90 days

3. Receives $219,568
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Money Market Hedge

If interest rate parity (IRP) holds, and
transaction costs do not exist, a money market hedge will yield the same results as a forward hedge.

This is so because the forward premium

on a forward rate reflects the interest rate differential between the two currencies.

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Currency Option Hedge

A currency option hedge uses currency call
or put options to hedge transaction exposure.

Since options need not be exercised, they

can insulate a firm from adverse exchange rate movements, and yet allow the firm to benefit from favorable movements.

Currency options are also useful for

hedging contingent exposure.
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Hedging with Currency Options

Hedging Payables with Currency Call Options Strike price = $1.60 Premium = $ .04
Nominal Cost for each $1.66 With Hedging $1.62 $1.58 Without Hedging 0 $1.58 $1.62 $1.66 Future Spot Rate 0

Hedging Receivables with Currency Put Options Strike price = $0.50 Premium = $ .03
Nominal Income for each NZ$ $.52 $.48 $.44 Without Hedging $.44 $.48 $.52 Future Spot Rate 11 - 17 With Hedging

Review of Hedging Techniques

To Hedge Payables Futures hedge Forward hedge Money market hedge Currency option hedge Purchase currency futures contract(s). Negotiate forward contract to buy foreign currency. Borrow local currency. Convert to foreign currency. Invest till needed. Purchase currency call option(s). To Hedge Receivables Sell currency futures contract(s). Negotiate forward contract to sell foreign currency. Borrow foreign currency. Convert to local currency. Invest till needed. Purchase currency put option(s).
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Limitation of Repeated Short-Term Hedging

Repeated Hedging of Foreign Payables When the Foreign Currency is Appreciating Costs are increasing Forward Rate Spot Rate

although there are savings from hedging.

0 1 2 3 Year The forward rate often moves in tandem with the spot rate. Thus, an importer who uses one-period forward contracts continually will have to pay increasingly higher prices during a strong-foreign-currency cycle.
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Hedging Long-Term Transaction Exposure

Long-Term Hedging of Foreign Payables when the Foreign Currency is Appreciating Spot Rate Savings from hedging 3-yr 2-yr forward 1-yr forward forward
0 1 2 3 Year
If the hedging techniques can be applied to longer-term periods, they can more effectively insulate the firm from exchange rate risk over the long run.

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Hedging Long-Term Transaction Exposure

MNCs that can accurately estimate foreign
currency cash flows for several years may use long-term hedging techniques.
Long-term

forward contracts, or long forwards, with maturities of up to five years or more, can be set up for very creditworthy customers.

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Hedging Long-Term Transaction Exposure

In a currency swap, two parties, with the aid of brokers, agree to exchange specified amounts of currencies on specified dates in the future. parallel loan, or back-to-back loan, involves an exchange of currencies between two parties, with a promise to reexchange the currencies at a specified exchange rate and future date.
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Cross-Hedging
When a currency cannot be hedged,
another currency that can be hedged and is highly correlated may be hedged instead.

The stronger the positive correlation

between the two currencies, the more effective the cross-hedging strategy will be.

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Currency Diversification
An MNC may reduce its exposure to
exchange rate movements when it diversifies its business among numerous countries.

Currency diversification is more effective

when the currencies are not highly positively correlated.

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